NSE Indices seeks market feedback on existing methodology of merger, demerger in Nifty Indices

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In an important development, NSE Indices Ltd is proposing revision in treatment of merger and demerger of index constituents for equity indices. Accordingly, it is conducting consultation with market participants to take their feedback on the same.

According to the announcement made on the evening on October 18, NSE Indices Limited is seeking market feedback through public consultation on treatment of merger as well as demerger in Nifty equity indices.

Current approach

As per the current practice, in case of merger or demerger of any index constituent, the reconstitution of index is undertaken when the equity shareholders of the merged entities give their approval for the merger/demerger. In fact, shareholder approval is considered a trigger to initiate the replacement of such stock. As a result, the exclusion of such stock is done much ahead of its ex-date of merger/demerger.

“More specifically, in case of event-based reconstitution on account of merger, index reconstitution takes place at the time of exclusion of the transferor company and subsequently weight rebalancing of the stocks in the index takes place when the shareholders of the transferor company are allotted shares of the merged entity and they are available for trading at NSE (in case the merged entity is a constituent of the same index),” said the circular from NSE Indices.

This results in churning of stocks twice in case passive funds (ETF/Index funds) are tracking such index. Further, in case of event-based reconstitution on account of demerger, index reconstitution and weight rebalancing take place at the time of exclusion of the demerged company (irrespective of its size in terms of market capitalisation or demerged business).

Challenges in current approach

In case, a transferor company is a constituent of an index and is merged into another company, which is also a constituent of the same index, index reconstitution and weight rebalancing get triggered on two instances.

First, during the index reconstitution, exclusion of the transferor company (and including another company as replacement) is done. On this instance, funds tracking the index will be required to sell the shares of the transferor company and rebalance the weights of the index constituents.

Second, weight rebalancing is done when the shareholders of the transferor company are allotted shares of the merged entity and they are available for trading on NSE. On this instance, funds tracking the index will be required to again buy the shares of the merged entity, which are allotted to the shareholders of the transferor company (post-merger).

Also, the transferor company is excluded from the index much ahead of its ex-date of merger.

Proposed approach

On the merger of the constituent entities, NSE Indices has proposed a new option, wherein the transferor company shall be excluded from the index on the ex-date (T Day) of merger, i.e. closing of T-1 day. Currently, the shareholder's approval acts as a trigger for the stock's exclusion from Indices and the stocks gets excluded much earlier than its due date.

The investible weight factor and capping factor (if applicable) of equity shares of the merged entity shall be updated based on the terms of merger on the ex-date of merger, i.e. closing of T-1 day.

The proposal also suggests that in case of indices with fixed number of constituents, a replacement of company will be made on ex-date, based on the eligibility criteria of respective indices in place of a transferor company which is being excluded.

Whereas in the case of indices with variable number of constituents, no replacement will be made on the ex-date in place of the transferor company which is being excluded.

The NSE Indices has also specified that the announcement of the above changes shall be made minimum three working days in advance for change in the constituents of indices, including the indices on which Futures and Options (F&O) are traded on NSE.

Experts at Nuvama Alternative & Quantitative Research believe that the new proposal should find support from participants. It is in favour of the new initiative as this will avoid big churning, which happens under the current methodology. For instance, in the case of the merger of HDFC Ltd with HDFC Bank.

“Thus, if these proposed changes are considered after the consultation is over, then HDFC Ltd will only get excluded on the ex-date (which will likely be Q1FY24). This is the standard practice followed globally,” the experts at Nuvama said.

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